What is money?
Money is defined not by what it physically is, but by what it does. Money allows people to engage in indirect exchange. Without money, people would have to barter, which requires a double coincidence of wants; one person must have what the other person wants and want what the other person has and be willing to trade. However, using money, people can sell what they have for money, and use the money to buy what they want.
Suppose you have 3 people: a farmer, a tailor and a carpenter. The farmer grows food, the tailor sews clothes and the carpenter builds furniture. The farmer wants clothes, the tailor wants furniture, and the carpenter wants food. Each of them wants to buy something, but they can not offer goods in exchange directly to the person they want goods from. However, if they have money, they can form a “circle of trade” where money flows one way and goods flow the other (see diagram below). The farmer buys the clothes from the tailor using money. The tailor takes the money and buys furniture from the carpenter. Finally, the carpenter buys food from the farmer. The money has gone around to each person, and everyone has what they want. With money, a circle of trade can be any size, and in a modern economy it can include millions of people!
Money did not spring out of existence from nothing; it evolved over time. In the ancient world (pre 1700), people used commonly desired goods as money, as well as tokens, metal coins and shells. Any good could theoretically be used as money, but some goods are better than others. Goods with more characteristics that promote exchange will tend to replace those with fewer. There are several characteristics that improve the functioning of money.
The most important characteristic of a money good is that it is universally accepted. The more people who accept the money in exchange for goods and services, the more who can engage in indirect exchange with one another. As long as you can find someone in the entire economy to buy what you have for money, you can buy any good from anyone else using that money. Money allows people to provide goods and services for anyone they like and in return purchase goods and services from anyone they like. It allows people to focus on their comparative advantage by producing one good and then trading it for the things they need. Without money, people would have to make several goods that were desired by those they wanted to trade with.
Second, money must be a “store of value.” All exchange takes place over time; you can't earn and spend instantly. It takes time to work and earn money, and time to spend the money. Some purchases need to be made every few days, such as food, and others need to be made rarely, such as buying a car or a house. Large purchases require saving, so if money lost value over time, it could not be used to buy those things.
Third, money must be portable enough for people to carry it conveniently. It must be durable so that it does not get damaged and become worthless over time. Additionally, money must be uniform so that people can display prices, write well defined contracts and define debts in a common unit.
Finally, the lower the opportunity cost of using the good chosen as money, the better. Using a useful metal, such as iron or bronze would be a poor choice for money, since that means society can not use that resource for other projects. Metal used as coins can not be used for tools, weapons or buildings. Gresham's Law states that “bad” money drives out “good” money. Bad money is defined as money with a low opportunity cost to being used as money. Bad money has lower valued alternative uses than “good” money. Gresham's law applies when there is a law that requires both monies to have the same exchange rate when used as money. For example, suppose there are gold coins and 50% gold, 50% copper coins, and the government declares them to be worth the same. No one will use the pure gold coins as money because gold has higher value alternate uses to being used as money. Eventually, only the debased currency will be in circulation, because people will use the pure coins for their alternate purposes. The ultimate expression of Gresham's Law is fiat currency, which has no value at all outside of its use as money.
The ideal money has many properties and desired characteristics, but goods used as money are not perfect. Over time better alternatives replace worse alternatives, just like technology improvements in other areas of the economy. The need for indirect exchange is one of the most critical requirements for an efficient economy, and money allows people to trade with whoever they want to get the goods they want most efficiently.
Suppose you have 3 people: a farmer, a tailor and a carpenter. The farmer grows food, the tailor sews clothes and the carpenter builds furniture. The farmer wants clothes, the tailor wants furniture, and the carpenter wants food. Each of them wants to buy something, but they can not offer goods in exchange directly to the person they want goods from. However, if they have money, they can form a “circle of trade” where money flows one way and goods flow the other (see diagram below). The farmer buys the clothes from the tailor using money. The tailor takes the money and buys furniture from the carpenter. Finally, the carpenter buys food from the farmer. The money has gone around to each person, and everyone has what they want. With money, a circle of trade can be any size, and in a modern economy it can include millions of people!
Money did not spring out of existence from nothing; it evolved over time. In the ancient world (pre 1700), people used commonly desired goods as money, as well as tokens, metal coins and shells. Any good could theoretically be used as money, but some goods are better than others. Goods with more characteristics that promote exchange will tend to replace those with fewer. There are several characteristics that improve the functioning of money.
The most important characteristic of a money good is that it is universally accepted. The more people who accept the money in exchange for goods and services, the more who can engage in indirect exchange with one another. As long as you can find someone in the entire economy to buy what you have for money, you can buy any good from anyone else using that money. Money allows people to provide goods and services for anyone they like and in return purchase goods and services from anyone they like. It allows people to focus on their comparative advantage by producing one good and then trading it for the things they need. Without money, people would have to make several goods that were desired by those they wanted to trade with.
Second, money must be a “store of value.” All exchange takes place over time; you can't earn and spend instantly. It takes time to work and earn money, and time to spend the money. Some purchases need to be made every few days, such as food, and others need to be made rarely, such as buying a car or a house. Large purchases require saving, so if money lost value over time, it could not be used to buy those things.
Third, money must be portable enough for people to carry it conveniently. It must be durable so that it does not get damaged and become worthless over time. Additionally, money must be uniform so that people can display prices, write well defined contracts and define debts in a common unit.
Finally, the lower the opportunity cost of using the good chosen as money, the better. Using a useful metal, such as iron or bronze would be a poor choice for money, since that means society can not use that resource for other projects. Metal used as coins can not be used for tools, weapons or buildings. Gresham's Law states that “bad” money drives out “good” money. Bad money is defined as money with a low opportunity cost to being used as money. Bad money has lower valued alternative uses than “good” money. Gresham's law applies when there is a law that requires both monies to have the same exchange rate when used as money. For example, suppose there are gold coins and 50% gold, 50% copper coins, and the government declares them to be worth the same. No one will use the pure gold coins as money because gold has higher value alternate uses to being used as money. Eventually, only the debased currency will be in circulation, because people will use the pure coins for their alternate purposes. The ultimate expression of Gresham's Law is fiat currency, which has no value at all outside of its use as money.
The ideal money has many properties and desired characteristics, but goods used as money are not perfect. Over time better alternatives replace worse alternatives, just like technology improvements in other areas of the economy. The need for indirect exchange is one of the most critical requirements for an efficient economy, and money allows people to trade with whoever they want to get the goods they want most efficiently.